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March 2009 Mutual Fund Red Flags

These small-cap funds are packing a lot of REITs.

Greg Carlson, 03/24/2009

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

Real estate investment trusts have taken it on the chin in the bear market. Declining property values, rising vacancy rates, and tight credit markets have all played a part in the struggles of these debt-heavy vehicles: The typical real estate fund (nearly every fund in the category invests very heavily in REITs) has lost a jaw-dropping 67% from the market's peak on Oct. 9, 2007 through the end of February 2009.

But it's not at all clear that the stocks represent good values now. True, valuations are down sharply and yields have risen from historically low levels. But financing is often difficult to come by, REITs' debt has grown as a percentage of their assets, revenues are generally declining, and some REITs will have sizable loans coming due in the next couple of years. Those that survive might end up posting great returns, but investors should keep in mind that REITs could prove to be a wild ride in general.

That warning isn't limited to real estate funds; most REITs land in small-cap territory, and a number of managers of diversified small-cap funds own hefty stakes in them. We'll highlight several of those small-cap funds this month and take a closer look at some of the REITs near the top of their portfolios.

Vanguard Small Cap Value Index VISVX
Yes, an index fund tops our list for REIT exposure--despite their price declines, the fund still had 11% of assets stashed in REITs at 2008's end. The position sizes in this fund are small (the index it tracks, the MSCI U.S. Small Cap Value Index, contains nearly 1,000 stocks), so an individual blowup or two shouldn't hurt too much. But that hefty overall stake still makes us wary.

Top-25 holding Essex Property Trust ESS recently had a respectable balance sheet, but its exclusive focus on West Coast apartments means a worrisome lack of diversification. Alexandria Real Estate Equities ARE is up there, too; its debt/assets ratio is similar to that of Essex, although it's having an easier time covering interest costs and its ties to giant health-care firms should stand it in good stead. As for the fund, keep in mind that even though it tracks a small-value index and thus shouldn't deliver extreme relative results, it is capable of landing in the small-value category's bottom third in a calendar year.

Schneider Small Cap Value SCMVX
This fund has had a brutal stretch of performance, lagging the typical small-value fund by double-digit percentage points in both 2007 and 2008. (And it lost 47% the latter year.) One reason: Its sizable stake in REITs, which recently weighed in at 11%.

Could shareholders be in for more pain? Thomas Properties TPGI, the fund's biggest REIT holding, has a hefty 80% debt/gross real estate assets ratio, and it was having trouble covering its interest costs in 2008's third quarter as revenues dropped. Manager Arnie Schneider boasts a fine long-term record and could mount a big comeback, but this fund (which also owns big stakes in its top holdings) courts plenty of risk.

Fidelity Small Cap Value FCPVX
Its REIT stake may not be as big (9%), but this fund also sports a 9% stake in some of the diciest corners of the financial sector right now. On the REIT side, the fund owns a 2.3% stake in the debt and a 1.3% position in the equity of SL Green SLG, which owns Manhattan office towers and thus has been hit hard by the slowdown. That firm is currently doing a fair job covering its interest costs, but it has a sizable chunk of debt coming due in the next three years.

In addition, the fund's current manager, Charles Myers, has been at the helm for just eight months (and is the fund's third manager in less than five years of operation). We'd steer clear of this one.

Greg Carlson is a mutual fund analyst with Morningstar.

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